Trading the Mark:The Hidden Importance of Fair Value
By Bill Johnson
Vincent Van Gogh said, “Great things are done by a series of small things brought together.” Investing works much the same way, and financial success comes from doing a lot of small things correctly. Options, however, have a lot of moving parts, and it’s easy to overlook the things you can’t see. One of the biggest mistakes I’ve seen with new options traders – and experienced ones – is misunderstanding the importance of fair value.
Fair value is a financial concept, which is simply a price that neither benefits the buyer nor the seller in the long run. In other words, it’s a price that’s fair to both parties. If the price always benefited the buyer, traders would bid the price higher until that benefit was priced away. On the other hand, if the price always favored the seller, more sellers would enter the market, push prices lower, and eventually that benefit would disappear. But when we reach a balancing point and have a price that doesn’t benefit either party in the long run, it’s a fairly-valued asset.
To understand the concept of fair value, consider a coin toss. If I toss a coin and offer to pay you one dollar if it lands heads, you should be willing to pay me one dollar if it lands tails. If you do, neither of us would be expected to come out ahead if we played this game thousands of times. We would expect to just break even in the long run.
However, if you paid me just slightly more, say $1.05 each time it lands tails, it would no longer be fairly valued, and I would have a long-term edge. In fact, if we played this game one thousand times, you’d end up on the losing side of the bet, as shown in computerized simulation below:
In other words, because you’re paying more than fair value, you’re heading into a financial black hole. No matter what strategies you try, or what methods you concoct, you’re going to lose money. It’s like the old business school joke of the guy who sold inventory at a loss but tried to make up for it in volume. The more you play the game, the deeper in debt you go.
The concept of fair value is exactly what allows casinos to win in the long run. Casinos make money by paying off winners at less than fair value. If you win $1,000 at roulette, it might look like you came out ahead, but if you compared it to the odds you overcame to win that money, you were short changed. Contrary to popular belief, it is the winners who pay for the pleasure of gambling. In other words, the winners actually lose. The idea to understand is that when you pay above fair value or receive less than fair value, it’s a little thing that magnifies into big losses.
Options trading works the same way. Every options contract has a fair value, which can be found through a pricing model. Most platforms will show them as the “mark,” or the midpoint between the bid and the ask. However, most traders get impatient and buy their options at the asking price and sell them on the bid. Doing so, however, you subject yourself to a house edge on the way in – and on the way out. Without even counting the effects of commissions, it’s most likely going to lead to long-term losses. For instance, look at the screenshot of the Nvidia (NVDA) quotes below:
The stock was trading for $250, and the $250 call had a mark of $10, as shown in the third column. However, if you bought the option on the asking price (column 2), you’d pay $10.10, or 10 cents higher than fair value. On the other hand, if you sold the option for the $9.90 bid (column 1), you received 10 cents less than fair value. It seems like a small thing, and it probably is for a trade here or there. But if you keep buying on the asking price and selling at the bid, those little things add up to big losses. To make great strategies come alive, you must do a lot of little things well. Start by placing your options orders as limit orders at the mark. Be patient. If it doesn’t fill, it’s a missed opportunity, but that’s better than a filled order above fair value.
Options traders have a host of strategies available to them that simply aren’t available to stock traders. By using options, traders can hedge, roll, and morph positions, which allows them to stay in trends much longer than they would be willing to by using shares of stock. That’s where the big money lies. It’s exciting – and rewarding. But to master the art and science of options trading, you can’t just focus on the big strategies. To make them great, you must bring small things together.
Good Investing!
Bill Johnson, Steve Bigalow
and The Candlestick Forum Team
P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.
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